One of the downsides of using ETFs—as opposed to index mutual funds—is that dividends and interest are not automatically reinvested. Instead, they are paid in cash, where they often sit idly in your brokerage account for months. This happens even more frequently now that many ETFs have started paying distributions monthly, rather than quarterly as in the past.

To address this issue, both Claymore and BMO offer dividend reinvestment plans (DRIPs) for their ETFs. For those who are unfamiliar with DRIPs, they allow investors to receive distributions—whether dividends from stocks, interest from bonds, or return of capital—in new shares rather than in cash. Only whole shares are possible: so if the ETF is trading at $20 and you’re eligible for $67 in dividends, you’ll receive three new shares plus $7 in cash.

If the amount of email I am receiving is any indication, these programs are extremely appealing to investors. Indeed, I have heard from people who are specifically choosing ETFs from Claymore and BMO rather than those from iShares because of the DRIP feature. (iShares does not currently offer such a program.) I believe this is an error in judgment.

While the automatic reinvestment of dividends is convenient, it should not be a major factor in determining which ETFs you use to build your portfolio. Here’s why:

Synthetic is just as real

ETF investors may not realize that discount brokerages offer “synthetic” dividend reinvestment plans. Unlike traditional DRIPs, which originate with the company issuing the stock or ETF, a synthetic DRIP is handled on the brokerage side. The ETF pays its distribution in cash, and the brokerage then purchases new shares in your account, without charging a commission.

There is no meaningful difference between the DRIPs offered by Claymore and BMO and the synthetic plans offered by brokerages.

Every brokerage handles things a little differently, and not every ETF is eligible, but most of the major firms support synthetic DRIPs for iShares ETFs. When I put the word out, investors confirmed that is the case at TD Waterhouse, CIBC Investor’s Edge, RBC Direct Investing, Scotia McLeod and iTrade. If you use another brokerage and can confirm whether they offer this service for iShares ETFs (and if so, for which specific funds), please share with your fellow Couch Potatoes by leaving a comment at the bottom of this post.

Don’t let DRIPs be the driver

The most important factor in your decision should be the investment strategy that the fund uses. Even if your brokerage does not allow you to DRIP a specific ETF you’re considering, it shouldn’t influence your decision.

The fact is, over the long run, whether you use DRIPs or simply collect your distributions in cash and reinvest them a couple of times a year (any time you add new money or rebalance) is not likely to have any significant effect on your returns.

The same can’t be said about ETFs that use different strategies. Most iShares equity ETFs are traditional cap-weighted index funds, while Claymore’s flagship products use a fundamental indexing strategy. BMO, meanwhile, has introduced a number of ETFs that use an equal-weighted strategy. Over time these differences are likely to have a much greater effect than the immediate reinvestment of dividends.

All of these ETFs may be good choices, and no one knows which of these strategies will outperform going forward. But the point is that you should select your investments based on your confidence in the strategy, not on the availability of a DRIP.

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@Ben: It’s important you understand the tax rules here. A DRIP makes no difference when it come to the taxation of dividends: whether you receive the dividend in cash or in the form of new shares, you still pay tax on it. But this applies only to non-registered accounts: dividends are not taxed if the ETF is held in a TFSA.

Nightrider
February 28, 2013 at 10:37 am

Great blog. I learned so much here. Especially, many contributors have given a perspective that one can only glean from many hours of spent time with one’s broker. I should have been more careful in the past. Now I know why I am a laggard when it comes to improved investments. Thanks CCP…!!

The full service broker I used is a dud. Name shall remain hidden. He never mentioned anything of this sort and never kept me informed except for monthly statements which I never bothered to even open because the performance was poor. All his interest was to line his own pockets. Old adage: NO ONE will care for your money except you. If you are a young person reading this, be very careful with whom you deal and trust your money. I am so glad I switched to discount broker. Things are looking up already.